This edition of “Ask the Expert” is brought to you by Denali Financial Consulting. We asked Jennifer Edson, their CFO and COO to share her thoughts on financial mistakes Founders often make and how to avoid them. Read on for her insights.
Q. Tell us a little about how you work with Startups?
I’ve been working with start-ups for over two decades. Most founders want to raise capital, but they may not know how to properly prepare for that. That’s where I come in — to help make sure the company is ready for the next phase. In most cases when I have engaged with a new client, the accounting has not been done correctly, and a significant amount of fees are spent trying to get the books prepared in accordance with GAAP (Generally Accepted Accounting Principles). Sometimes I am called at a critical juncture to aid with due diligence, and the clean-up is so significant, companies lose out on otherwise interested investors because they cannot produce financial statements that accurately reflect the position of the company in a timely manner.
Q What are some of the most common financial mistakes you have seen founders make?
To help Founders stay on the right path, here are four mistakes I have seen founders make that can hinder a successful round of funding:
- IMPROPER REVENUE RECOGNITION
Account for revenue when it’s earned – not when it’s received.
Revenue recognition is a big one that’s most often done incorrectly. When is revenue recognized and how do you account for it? There is an accounting standard called ASC 606, which provides a 5-Step framework that must be used to recognize revenue correctly so that financial statements are prepared consistently. A lot of our clients are SaaS (Software as a Service) companies and follow a subscription-based revenue model. ASC 606 can be particularly interesting to apply to SaaS companies because several contract components may need to be evaluated for proper revenue recognition. Add to that commission and cost of sales related to that revenue, and it can be fairly technical to apply the standard.
Companies that do not follow ASC 606 often book too much revenue up front. If revenue is recognized incorrectly, it will eventually have to be restated and the results often are not favorable and can be very problematic if a company has been presenting a more positive financial picture than GAAP allows.
2. CASH VS. ACCRUAL BASIS
It matters to investors – not just auditors.
When I send them the invoice and receive the payment, I’ll record it” or “when I pay for a service or product, I will record the money I spent” but this is not best for management purposes, nor is it GAAP compliant. For example, on the expense side: Cash basis accounting: If you signed an annual software contract in January, and paid for it in February, using cash basis accounting you have an expense of $12,000 in February on your profit and loss statement since that was the month of the cash outflow.
Accrual basis accounting: With this method, you will reflect that the true software expense is $1,000 a month for 12 months. You would record expense in January of $1,000 when you sign the contract and then prepaid expense for $11,000 which you will then amortize (or expense pro-ratably) over the rest of the contract period from February through December by setting up a prepaid expense account.
Most startups have a cash basis mess going, or often some hybrid of cash and accrual basis. And anytime you are going to raise capital, you have to use accrual basis accounting as it is required by GAAP.
3. INCORRECT CAP TABLE: Or worse, none at all!
Once a founder has raised any capital at all, or even put in their own equity, the first thing they have to do is to get their equity captured correctly in the books. Anytime you ask anyone to invest in your company, they are going to ask you what your capitalization table looks like.
Many experienced founders will tell you their first stop is to get an accountant and an attorney, and to get a tool like Carta set up so that they are tracking their equity properly. We often find new founders don’t know where their stock purchase agreements are, or if they do have them, they sometimes have not been properly executed. Reconciling the ‘Cap Table’ is one of the first things we do.
Side note: most start-ups are not accurately reflecting stock issuance costs, so that typically has to be corrected. Having an incorrect Cap Table or worse, no Cap Table, can definitely hinder a round of funding!
4. NO FINANCE TECH STACK
Our preferred finance tech stack
Picking a tech stack that you can grow with is a very important piece of being ready to raise a round of funding. We find that many early-stage start-ups are using: some sort of spreadsheet tool in combination with their chosen accounting software (that the most willing participant in the company — often a non-accountant — is wrangling), as well as some sort of payment processing system such as a Stripe.
In many cases, there is no one determined system of record, and the numbers often aren’t consistent between the different methods used to track sales and expenses. This makes accurate reporting next to impossible and that is a turn off to investors. When we are engaged, we recommend a standard tech stack and encourage companies to streamline their processes using these tools.
We have chosen these tools because they are cost effective, scalable, easily integrated with apps and each other, and are widely used. Our preferred tech stack is:
QuickBooks Online (QBO) for the system of record
Gusto for payroll
Bill.com for payment processing
Carta for equity tracking
Expensify for expense tracking.
QBO in particular is the most widely used accounting software for companies with revenue up to $10M (according to a survey published by Sage Intact), and we find it has a lot of very useful apps that integrate with it.
Q. How important is it to hire an accountant for an early stage startup?
Founders don’t always understand where accountants add value at first. They may not feel like bookkeeping is critical. But I have seen time and time again where that road leads, and it always costs you in the long run — jeopardizing your chances for fund-raising and investment. It is much less expensive to start with someone knowledgeable upfront so you have peace of mind that your finances will be attractive to investors.
One of my clients is a seasoned start-up veteran, and I was one of the first phone calls he made. I asked him about it, and he said, “Oh, after two start-ups where I didn’t pay much attention to the accounting and got burned, by the third time, I realized you need an accountant — a good accountant – up front.” He said, “That’s always what I do first. I hire an experienced attorney and a good accountant.”
Make sure your finances are in good hands from the start. If you’d like help, please reach out to our team of financial experts, accountants, controllers, and fractional CFOs.
Jennifer L. Edson is the COO of Denali Financial Consulting. She is a Certified Public Accountant specializing in the Finance role in early-stage start-ups. Her expertise includes QuickBooks Online implementation, integration and training, audit preparation, due diligence, budgeting, cash management, cash flow projection, financial analysis, start-up consulting, tax preparation, day to day and monthly accounting duties, payroll processing, ASC 606 implementation, 409a valuation assistance.